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25 August 2011

U.S. Economy Falling Farther Behind

While Washington was busy debating whether or not to sabotage the recovery by failing to raise the federal debt ceiling, the economy seemed to be doing everything in its power to demonstrate that it’s in feeble health to begin with.
Leading indicators, like an index of manufacturing activity, have printed poorly, about at the levels that suggest the economy is on the brink of another recession. Although bearish economists have been warning about recession risk for some time now — and looking the wiser for it — concerns about a double-dip have crossed into the mainstream. The Harvard economist Martin Feldstein thinks there is a 50-50 chance of another recession. We may even be in a recession right now.
In some sense, however, this is beside the point. The American economy lost a ton of ground during the global financial crisis. Slipping back into a recession — meaning negative growth — obviously wouldn’t help matters at all. But neither, really, would slow growth of the sort we have experienced during the first half of the year.
In the chart below, the United States’s gross domestic product, adjusted for inflation, dating back to 1877 is plotted. The data incorporates the recent substantial downward revisions to G.D.P., which suggested both that the economic crash was even worse than economists had previously believed — at one point, G.D.P. was declining at an annualized rate of nearly 9 percent — and that the recovery has been even more timid.
G.D.P. is plotted on a logarithmic scale in the chart, which reflects the fact that, over the long-run, the American economy has been growing exponentially. The rate of growth has in fact been quite steady over the long run: since 1877, the annual rate of G.D.P. growth has averaged about 3.5 percent after inflation. There has also been strong a tendency for these numbers to revert to the mean: periods of above-average growth have generally been followed by periods of below-average (or negative) growth, and vice versa.
So far, however, there has not been much of a rebound from the Great Recession. In the next chart, the plot displays how far ahead or below of the long-term trend that the economy is at any given time. Basically, instead of thinking about the economy in terms of the rate of growth, we’re instead thinking about how strong or weak it is in an absolute sense. An economy may technically be out of recession — meaning, that it is no longer shrinking — while still being well below its productive capacity.
Here, you can really see the effects of the Great Depression. In early 1933, G.D.P. was about 40 percent below what it “should” have been based on long-term growth rates. But the economy recovered at a rapid clip over the course of the next decade. In fact, G.D.P. temporarily overshot, exceeding the long-term trend during World War II as America employed all the industry and labor that it could get its hands on to help with the war effort. 
By this measure, most post-World War II recessions are barely detectable. They look more like reversions to the mean after years of above-average growth. The Great Recession, however, is highly visible. G.D.P. had already been a couple of percentage points below the long-term trend before it began, as the recovery from the 2001-2 recession was not particularly robust. But things got much worse in a hurry.
Looked at this way, in fact, not only is the worst not yet over — the situation is still deteriorating. Every quarter that the economy grows at a rate below 3.5 percent, it loses ground relative to the long-term trend. Although the economy grew at a 3.8 annual percent rate from fall 2009 through summer 2010, over the past year growth has averaged just 1.6 percent, putting us farther behind.
Right now, gross domestic product is about $13.3 trillion dollars, adjusted for inflation — when it “should” be $15.7 trillion based on the long-term trend. That puts us more than 15 percent below what we might think of as full output, by far the worst number since the Great Depression.
If the economy were to enter another recession and shrink by 1 percent over the course of the next year, we would wind up 19 percent behind the long-term trend. But even if it were to grow at 2 percent, we would still be 17 percent behind. What we need, instead, is above-average growth — in fact, quite a lot of it. Even if the economy were to begin growing at a 5 percent annual rate, it would take until 2018 for it to catch up to the long-term trend.

23 August 2011

Managing Risk in this Market

Part of a good defense in investing is knowing the impact of losses and why we want to keep them small. Losses do not get better as they float downstream. Look at what an investor has to make back each time they take an excessive loss and this is just to get back even:

  • 25% loss = 33% gain to get back to where you started
  • 33% loss = 50% gain to get back to where you started
  • 50% loss = 100% gain to get back to where you started
  • 75% loss = 300% gain to get back to where you started

These are the numbers. Having them top of mind might help when you get tempted to make a high risk trade with your hard earned money. It is not very hard to lose 50% on a stock these days, even in “defensive” stocks. When was the last time you made a 100% on a trade in this market?
All stocks are risky; every trade entails risk. Managing that risk is critical for long-term success. Besides proper stock selection and timing, handling losses is the most important part of risk management. In most firms, if they are down 7% on a position, they close it. Period. You should never let the story or the fundamentals override a loss. Never, no matter how much you like the company.
Numerous emotional traps are avoided by staying disciplined with these rules. To further put the odds in our favor, we always consult a stock chart before making a trade. Where a stock is on the chart is as important as a good story with solid fundamentals. In your shop, defense should always comes first.

21 August 2011

Week Ahead: Will We Bounce?

With the S&P looking vulnerable, will stocks retest the August lows? In a nutshell we say yes, the market will retest the lows. But we also believe that technical signs suggest the lows should hold.
The trouble is that  too many investors expected the stock market to just bounce and historically that is not what happens. Typically the market makes 'W' bottoms; we make a low bounce and re-test the low bounce and re-test again. This pullback could provide an important - and potentially bullish tell. As we pull back we will be finding out if people will again buy stocks at the August lows (of about 1120 on the S&P). How it plays out over the next 3-4 days will be critical.

11 August 2011

S&P Downgrade: The Only 2 Questions You Should Be Asking

As a normal investor who has colorful fantasies and nightmares regarding the financial markets, there is a better than even chance that following yesterday’s route you have a flood of thoughts swirling around your head. The fact that all of the information contained in the entire world, along with the opinions that come in tandem with that information are at your fingerprints may seem like a blessing during times like this. However, it is more often than not a curse. Simplification is the only answer.
There are only two things you need to be concerned with as an investor currently:

  1. At what point should I raise more cash?
  2. Where will be the point at which I should put that cash to work?

That is it. Your problems have all been condensed into two basic questions that you must now answer.
For reasons that I outlined in an article I wrote over the weekend, I believe that the S&P 500 is headed for 1150 on the downside, as a minimum target. This downside target is gaining increased credibility as I am not seeing the proper levels of panic amongst investors as of yet. The attitude remains one of “at what point can I buy in for a bounce” as opposed to “the thought of being long the stock market makes me want to vomit”.
What will get us to that vomit point is a continuing pattern of failures in the market that should take place over the next few days, weeks and possibly months. Nothing makes traders and investors give up on the long side like a continuing pattern of rallies that fail. That is exactly why you see so much chop around important market bottoms. That chop or volatility is the motion of an ocean of investors not being able to sustain the torment any longer.
The fact that we will be experiencing rallies along the way means that investors will have multiple opportunities to lighten up on their long positions. In the midst of the snap back rally you will see a lot of false hope and optimistic expectations that the worst is behind us. It will not be. Barring some type of surprise intervention from the Fed, ECB or combination of the two, there is little chance of a sudden “V shaped” bottom taking place. The damage has simply been too great and there will be too many investors maneuvering into the markets during subsequent rallies. This maneuvering will inevitably cause the choppy, violent movement that is typical of bear raids on the stock market. It is a long, drawn out process that will need a month or two of work, at a minimum.
A move above 1250 on the S&P 500 should be used as a point to lighten up on long positions. I would expect to see this take place over the short term as the downside is extremely compressed. A move below 1160 on the S&P 500 is the point that the cash should be maneuvered back into the markets with an intermediate to long term time horizon. September seems more than appropriate to see the type of panic necessary to put in a sustainable bottom. October at the latest.
During the point in time when this type of frightening decline takes place, Wall Street will make sure to pull out all the photos of past monsters, goblins and vampires to frighten away all but the bravest of investors. It is the equivalent of telling a small child to stay away from a closet where you keep your valuables with stories of a three legged, reptilian creature that wears scary hats.
2008 is sure to come up, as this has been the scariest monster of all. The market will want you to think that the monster of 2008 has come to revisit us in 2011. And as usual, what the market wants you to think will be the least profitable path of thought one can take.

09 August 2011

"We got Greeced": Nicknames for the Crash

Given that CNBC is going to be "all downgrade all the time", CNBC reached out to folks on Twitter for alternative words or phrases to replace "downgrade". It gets boring saying the same word over and over. They got a lot of replies, some not printable. Here are a few worthy suggestions:
  • "We got Greeced"
  • "Inverted upgrade"
  • "Negatively elevated"
  • "D-listed"
  • "Not Winning"
  • "Value challenged"
  • "The Fredo Corleone of sov debt"
  • "S&P to US: 'I will cut you!'"
  • "US downgraded from Hamlet to Horatio with negative Guildenstern watch (sorry, I'm watching Hamlet)"
  • "S&P has placed a 'Pitchy Dawg' rating on long term US Treasury Debt"
  • "Donkey punched, Dirty sanchez'd, Rusty tromboned"
  • "Deuce drop"
  • "Unfollow"
  • "Put in a time out"
  • "Un-friended"
  • "Type O Negative" (get it?)
  • "Kardashianed"
  • "US debt has gone from Rory McIlroy to Tiger Woods"
  • "We've gone from Moe to Larry"
Which is your favourite?

07 August 2011

How Low Can the S&P Go?

"(Squeaky Voice) How low can you go?! [8x]Luda!She could go lower than I ever really thought she could" - Ludacris How Low 
The recent selloff in stocks has triggered a scary "head and shoulders" pattern in the S&P 500 chart, signaling that there may be more selling to come. Oh, and there is this little thing called a debt downgrade that has sent global markets down 7% (Middle East) and 3% (Asia). The so-called head and shoulders pattern is formed when the chart pattern shows three rallies, with the middle rally peaking higher than the first and second, thus creating a head. If the market breaks the "neckline," that is a trend reversal signal and can mean more selling ahead.

What we are in the midst of is a classical technical breakdown. When the S&P broke down through the 1248 to 1250 region, it violated the neckline on a head and shoulders formation. If it is a valid head and shoulders then you begin a countdown to where it occurred. That would take the market down to approximately 1120. To reverse itself, we would need to see the market go above the neckline at approximately 1248.
In the chart, the market first rallied, forming the top of the left shoulder in late February. It then rallied to a higher level, forming a head in May. It then dipped down to a neckline before rallying to form a right shoulder in July. Typically, the neckline is formed at an area of prior support. That would be the 1249 to 1280 zone.
Wednesday's move down through 1249 was the bottom end of the neckline which traders have been watching. That, combined with European debt issues, precipitated the further sharp selloffs. What a head and shoulders tries to do is it tries to measure the potential move of a correction and the way you do that is from the top of the head to the neckline. The high was 1370. The neckline would be an average of 1270. That gives you a measured move for technicians to pick an area to buy. That takes you down to a zone of 1150 to 1180. That correlates to a pretty big support level from last year. That will be the level traders are watching. Sometimes market's bounce back up after breaking the neck line, in a "kiss back" move, and that is what happened Wednesday when stocks recovered most of their losses to close slightly lower.
To short the market, I use ProShares UltraShort S&P500 (ETF: SDS). I have been in this for a few weeks now; however, as Mark Chan cautions, this investment is extremely volatile and is not for those that are not at least a little "insane in the membrane". Keep your stop loss tight and trailing. 

01 August 2011

8 Things Worth Teaching an MBA

Listen up, budding Masters Of The Universe, and all those who dream of walking their path to wealth, power and spacious summer homes. At many business schools, boot-camp week–where the unwashed get a taste of debits, credits and such–starts in less than a month. After that, and just beneath the throb of your hangover (a B-school accessory), you will detect another inexorable rhythm–a faint ticking to be precise. This is the tell-tale heart to your two-year, $100,000 investment. The relentless reminder that you better get to learnin’ (or at least networking), lest you end up working for, and maybe getting laid off by, one of your classmates one day.
Now for the good–or totally vexing–news, depending how you take it: After all the spreadsheets and etch calculations, after all the case studies and Power Point presentations, after all the tuition money is gone and it is just you and your pedigree, contacts and gumption, guess what?
You get to start over again–in the real world.
As anyone who employs people and writes checks will confirm, turning $1 into a $1.10 is a real bitch. Turning that $1.10 into $1.25, even tougher. I had to laugh the other day when I saw on Google+: “Generating positive cash flow is one of the hardest f—ing things in the world.”
For all the wonderful instruction at places like Harvard, Wharton and my alma mater, DePaul University, b-schoolers should remember that making money involves so much more than columns in a spreadsheet and the ever-shifting assumptions behind them.
With that in mind, here’s a supplemental, 8-step curriculum:
  1. If It Ain’t Broke, Still Fix It: One of the hardest decisions business owners have to make is turning their backs on cash when it is flowing. But that is exactly what you must have the courage to do sometimes to protect your franchise. Think about all those aggressive mortgage underwriters who scooped up fees by the shovelful during the housing bubble, when they should have been tightening their lending criteria. Or USA Inc., which ran deficits for years–because, well, our creditors did not seem to mind–and now faces a staggering $60 trillion fiscal hole (including the present value of all future obligations to its entitlement programs).
  2. If You Don’t End Up Working At Goldman Sachs, Forget What You Learned About Finance: In my entire finance career with large respected companies, I can count on two hands the number of IRR (internal rate of return), DCF (discounted cash flow) and NPV (net present value) analyses I have completed, and I am pretty sure that I analyzed exponentially more balance sheets in a classroom than I ever have in a boardroom.
  3. Take Your Financial Models With An Indiana-Jones-Sized Boulder Of Salt: Another biz-school mate, now a health care consultant, chimed in with this stern admonition: “Too often people in business rely upon a model demonstrating projections out 15 – 30 years.” I was astounded: Fifteen to thirty, I confirmed? In school we worked in more modest 3-to-5-year increments, with an understanding that anything beyond that was magical thinking. “Believe it or not,” he went on, “I have seen some done out that far for deals [acquisitions] and often for public-private partnerships.” Find me an industry (save for perhaps utilities) where the assumptions you make today apply for three years, let alone 30. No, really, find me one.
  4. Overpromise And Try To Deliver: Under-promising and over-delivering may work on conference calls with Wall Street analysts who need earnings projections for their valuation models. (GE made an art out of that game for years under Jack Welch.) But that strategy will not always cut it when chasing new business to meet growth targets (or just payroll). Sometimes you will have to bite off more than your models–and your gut–say you can chew just to win the business. It’s an uncomfortable sensation at best, and a reputation-damaging maneuver at worst if you don’t come through. Get ready–and no tears.
  5. If You Do Not Know Who The Sucker Is, It Is You: Yet another B-school colleague of mine, who probably plays too much poker, recalled this adage, a favorite of mine: “People are happy to take your money by pulling you off your home court,” he says. “Don’t let them. Deploy capital in ways that you understand not only intellectually, but also viscerally. Stick to home games–that’s where your instincts will flourish.”
  6. If No One “Owns” A Project, It Will Not Get Done: Most people do not put in long hours for their health, or to make shareholders wealthy, or because their families drive them nuts and they would rather grind it out in the office. (Okay, sometimes that last part is true.) They do it because their job demands it, and with any luck they take a lot of pride in doing it well. Which is why all projects need champions. Not the kind who beats his chest and spews happy mission statements. The kind whose backside is on the line if things do not pan out. More importantly, the kind who has the authority and resources to make decisions that other people have to follow, else their backsides are on the line. It is not that people are lazy or incompetent (they may well be, but that’s a hiring issue). It is that, over time, you get what you incentivize–or do not.
  7. Be Clear: They actually do tell you this one in b-school, but not in so many words and not vehemently enough. The clearer you are, the more thoroughly you probably understand what you are talking about, and the more capable and trustworthy you will seem to customers, colleagues and employees. Being clear has immense ramifications–on productivity, customer satisfaction and employee morale. If your Power Point deck contains the word “ideate,” cut, and do not paste. In fact, eliminate all jargon from everything you do. (If you think the word “utilize” is a smarter version of “use,” please, please read The Most Annoying Business Jargon.) This applies to electronic exchanges as well. The simplest, most straight forward emails can, and will, get twisted beyond meaningful comprehension. If the message is mission-critical, communicate face-to-face, or by phone, as best you can.
  8. Business Involves People: People are a pain. They whine, mess up and have all sorts of problems. That is why every now and again you should ask how they are doing–and actually listen to the answer. It does not cost a cent and helps lift spirits and build trust.